The new rules of F and O trading

The stock market regulator's nod to physical delivery of equity derivatives could pave the way for major changes in the F&O (futures & options) segment and cut down on speculative activity that has been the bane of small investors. The physical delivery rule will raise the entry barrier to the F&O segment, and keep the small investor out—perhaps for his own good. The Securities and Exchange Board of India (SEBI) is discussing the issue with stock exchanges and will announce detailed guidelines on derivative trading after the deliberations.

The existing position: Right now, equity derivatives are settled in cash. If an investor bought a futures contract of Reliance Industries at a price of Rs 1,050 and sold it a few days later when it touched Rs 1,100, he would pocket the difference between the buying and selling price. With a lot size of 300 shares, that would be a profit of Rs 15,000.

What will change: If physical delivery is introduced, the buyer (or seller) will have to buy or sell the shares under the contract. That raises the entry barrier to the F&O segment. Right now, the investor has to submit about 20 per cent of the contract value as margin money with the broker. But if physical delivery becomes the rule, a buyer will have to keep cash ready, while a seller will have to arrange shares.

Push for index derivatives: With equity derivatives out of reach because of the large outlay required, small investors and speculators may move to index-based derivatives. These are less volatile than equity derivatives because the risk is spread over several scrips.

What's not clear: SEBI hasn't clarified whether the physical settlement will be optional or mandatory. Also, we don't know whether the physical settlement for equity options will be applicable only on the expiry of the contract (as in case of index options) or whenever the buyer chooses to exercise it.

SEBI might have second thoughts on physical settlement in options as it could mean that the interest in this crucial hedging instrument wanes.